Wall Street Yawns as Chinese Real Estate Giant Close to Default: What Investors Need to Know

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Evergrande, a Chinese real estate giant with more than $ 300 billion in debt, is likely to default next week. Global investors don’t seem too worried, but the looming crisis still has the potential to shake financial markets, analysts have warned.

“While Evergrande’s bonds and stocks have been sold, the spillover to other assets, both in China and abroad, has so far been limited, suggesting that investors are convinced that the country’s authorities will limit any financial contagion, “said Thomas Mathews, market economist at Capital Economics, in a note.

Fears of a housing bubble bursting have long been a concern for investors when it comes to China. A heavily indebted real estate sector represents more than 28% of the Chinese economy, according to the Financial Times.

And the dire situation at Evergrande sparks debate over how Chinese authorities should respond. Meanwhile, holders of around $ 19 billion of Evergrande’s dollar-denominated bonds are wondering what will happen to their investments. And shares of Evergrande 3333,
-3.42%
plunged 83% in Hong Kong.

World markets have been largely unwavering. Major US stock indices were on track for weekly losses, with the Dow Jones Industrial Average DJIA,
-0.48%
down 0.1% and the S&P 500 SPX,
-0.91%
on track for a 0.5% drop. These modest losses, however, were largely attributed to concerns that stocks were overdue for a pullback amid uncertainty over the toll of the spread of the delta variant of the coronavirus.

Should investors pay more attention to the Evergrande situation?

FitchRatings, a credit rating agency, downgraded Evergrande’s rating to CC from CCC + on September 7, indicating that they considered some sort of default likely. Evergrande is one of China’s top three real estate developers, although the residential housing market is highly fragmented, Fitch analysts noted in a Sept. 14 report.

Evergrande’s market share in 2020 was only around 4%. Fitch said the risk of significant pressure on house prices in the event of a default would be low, unless the restructuring or liquidation of its assets becomes haphazard. “Fitch thinks this is something the authorities will want to avoid,” the analysts wrote.

But faith in this scenario may have been shaken after Reuters reported that the editor of the state-backed Global Times newspaper warned that Evergrande shouldn’t assume it’s “too big to fail.”

UBS analysts, led by Kamil Amin, said in a note on Thursday that the potential for a fallout in the market will depend on the restructuring or complete liquidation of Evergrande. Analysts wrote what they remained convinced that a restructuring was the most likely outcome.

“In the event of restructuring, we expect bonds to rebound from their lows and contagion to be largely contained,” they said.

But in the event of liquidation, there would likely be a “high degree of contagion,” they warned. The fallout would occur, they said, through three channels:

  1. Investors are getting extremely low salvage values ​​which would lead to a loss of investor confidence in the wider real estate sector and the high yield Asian offshore market and spill over into Chinese financial assets at large.

  2. A domino effect of credit events, as both banks and non-banks with significant Evergrande exposures could potentially go bankrupt or be forced to restructure. This would again spill over into other Chinese financial assets and cause financial stocks to underperform, especially in both [developed market] and [emerging market] the credit / equity markets, led by these names with direct exposure either to Evergrande itself, its subsidiaries or its creditors.

  3. A full liquidation would involve breach of the Keepwell agreements (a written guarantee from a parent company that it will maintain the solvency of a subsidiary) – which we believe will force rating agencies to recalibrate their methodologies and remove several rating increases and assumptions of state support in non-real estate sectors, both in the offshore US dollar market and in the onshore market. This could lead to additional selling pressure and lead to significant liquidity distortions in the Chinese offshore and onshore bond markets, with the potential for an overflow into EM credit, as several EM credit accounts tend to hold bonds. Chinese offshore bonds as part of their Asian high level. performance exposure.

Why do investors seem to ignore the potential for spillover effects? The lack of concern reflects expectations that, in the end, “the Chinese government will end up paying for it,” Tom Essaye, founder and chairman of Sevens Reports Research, said in a note Friday.

“One of the best ways to think about China is that it’s a country, but it works
like a big company, ”he said. Although there are “private” banks and companies, at the end of the day, the Communist Party “actually owns anything and everything” if it wants to, he wrote.

“And because of that, there is really no risk of global contagion with Evergrande because ultimately, and as far as we know, the loans to Evergrande were made by Chinese banks which are implicitly backed by the Chinese government, and the Chinese government’s balance sheet can easily handle Evergrande’s losses which are valued at around $ 303 billion in liabilities, ”he said.

In addition, investors may take the Evergrande situation eagerly because China’s financial strains “were for some time seen as an idle train crash, not something that suddenly arose,” said Steve Barrow, Head of G-10 Strategy at Standard. Bank, in a Friday note.

Financial meltdowns, including Long Term Capital Management, Barings and Lehman Brothers, “have come out of left field,” he said, and have produced national and international shockwaves, he noted. But “China’s different financial support structure and the elongated nature of the difficulties may have desensitized global markets to the tensions that seem to be reaching their peak right now in the case of Evergrande.”

That said, investors have already been caught off guard by Chinese authorities, noted Mathews of Capital Economics.

It was only three weeks after the People’s Bank of China took over Baoshang Bank in 2019 that credit conditions deteriorated as investors reassessed the government’s implicit support in the sector, he said. , noting that authorities eventually intervened to stabilize conditions, preventing much of a reaction in markets outside China.

But 2015 saw wider ripples in the markets, he noted, as global equities fell sharply in August after Chinese equities fell 40%, authorities unexpectedly allowed the renminbi currency to fall.

Mathews argued that one of the lessons from these previous episodes is that “Chinese authorities would eventually step in to stabilize domestic financial markets in the event of a large-scale Evergrande default,” but could first allow for a temporary deterioration in prices. financial conditions.


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